Ofgem waters down financial resilience proposals

Back in July, Ofgem launched a consultation on plans to boost financial resilience in the retail energy sector, in which it made three key proposals:

• Protecting consumer credit balances and Renewables Obligation (“RO”) payments: Ofgem believes there is a “good case” for insuring or otherwise protecting customer credit balances and RO payments so they are available to a new supplier should the original supplier fail. This would reduce RO and Supplier of Last Resort (“SOLR”) mutualisation costs and mean that suppliers do not have access to free, risk-free working capital that may incentivise them to take excessive risk;
• Protecting the value of hedges for consumers: a significant proportion of the costs that all consumers were exposed to as a result of recent supplier failures was a result of the new supplier having to buy gas and electricity in the wholesale markets at higher prices that might otherwise have been the case (for example if they had known that they would have these customers), and these prices were much higher than the price allowed under price cap due to the rate at which prices increased last year. Although some of the failed suppliers had hedged, insolvency rules meant that those hedges were liquidated for the benefit of the suppliers’ creditors, rather than being transferred to the SOLR;
• Capital adequacy: Ofgem believes that suppliers should be required to maintain enough capital to survive market shocks. While current rules allow Ofgem to set capital adequacy expectations, it believes that more specific requirements are needed to increase supplier resilience and incentivise more robust risk management.

These met with a mixed reaction. Larger suppliers, notably Centrica, which already ring-fences consumer credit balances, were supportive, but challenger suppliers, including larger ones such as Octopus, were strongly opposed, saying they would increase their costs and reduce competitiveness relative to larger competitors with access to cheaper sources of finance. While these objections are legitimate, I do not think they are a good reason to dismiss these principles – any standards to ensure financial adequacy will favour larger companies, but this does not make it OK for poorly capitalised companies to participate in a market where at least some of the costs of failure are socialised. It is not mandatory for companies to operate in the retail energy market, so if they lack the financial resources to do so competitively they should think twice about entering the market (and those that already entered might have anticipated some tightening of the previously lax rules.)

Ofgem has now launched a new consultation, with significantly watered down proposals, dropping the ring-fencing of consumer credit balances entirely on the basis that it would impose costs on all suppliers and may result in “inactive” capital that could be “more effectively” deployed elsewhere.

The new proposals are:

• Enhanced Financial Responsibility Principle: an enhancement to the existing Financial Responsibility Principle set out in supplier licences to embed a minimum capital requirement for domestic suppliers, and introduce a positive obligation on suppliers to evidence that they have sufficient business-specific capital and liquidity to meet their liabilities on an ongoing basis. There would be a requirement on suppliers to inform Ofgem when they hit certain triggers indicating potential financial issues and to notify Ofgem ahead of paying out dividends when those triggers, or the minimum capital requirement, are hit. Ofgem would also have the power to require individual suppliers to ringfence customer credit balances if they fail to meet minimum capital requirements.
• Market-wide capital requirement: Ofgem proposed introducing a capital adequacy regime for suppliers. As the sector is currently under-capitalised, and raising finance may be difficult in the current economic climate, Ofgem proposes a staged approach to introducing full capitalisation requirements by setting a short-term target for suppliers of £110-220 per domestic customer of net assets by end of March 2025, with suppliers required to submit transition plans showing how they intend to reach the target. Suppliers would also be able to meet the requirement with alternative sources of funding such as Parent Company Guarantees where appropriate.
• Ringfencing RO receipts: While Ofgem continues to believe that legislation for more regular payment of RO receipts would be the optimal solution to address, in the absence of such legislation if believes that ringfencing is the right approach to reducing the risks of mutualisation. Unlike the case of customer credit balances, Ofgem believes there is a “principled case” for ringfencing money that was never intended to fund suppliers’ business operations but is simply a pass through arrangement which could circumvent suppliers altogether if the scheme were designed differently. As a result, it proposes a market-wide ringfencing of RO receipts from 1 April 2023, applying from the 2023/24 RO scheme year.

Predictably the reactions to this new consultation are the opposite to the reactions to the previous one: Centrica is leading the criticism, describing the move as “reckless” and “an abdication of responsibility by a regulator”, while challenger suppliers, led by Octopus Energy support Ofgem’s change of heart.

“When customers pay up front for their energy, they are trusting their supplier to look after their hard-earned money. They would be appalled to learn their money was being used to fund day to day business activities, but that’s exactly what’s happening in some companies, and it undermines confidence in the market…if and when a large supplier fails, the recklessness of the decision not to address this issue will be clear for all to see,”
– Chris O’Shea, Chief Executive Officer, Centrica

This is just a consultation, and Ofgem may yet change its position again, but if this goes ahead, the success of the measures will depend on the ability of Ofgem staff to analyse and react to data indicating a supplier is getting into difficulties in a timely fashion. It will also require that if Ofgem decides a supplier has to ringfence customer balances, the need to set aside incremental capital does not in itself push the supplier into insolvency, in which case it would not require ringfencing.

I’m not entirely sure of the logic of the proposal where a supplier is asked to set aside additional capital at a time it is already struggling…if the suppliers is in such dire straights that setting aside the necessary capital would place it in insolvency, and Ofgem therefore decides not to require it to do so, how are consumers protected? In order for this provision to work Ofgem would need to anticipate that a supplier that is not yet in difficulties will begin to have difficulties and intervene at the correct time. I can see a risk that suppliers appeal against such decisions on the basis that they may appear arbitrary and to a certain extent, speculative.

The consultation will run until 3 January.

The thorny question of ringfencing customer credit balances continues to cause controversy

Ofgem described the responses to its previous consultation on financial resilience.  It says that larger incumbent suppliers and some consumer groups broadly favoured its proposals while other respondents, mostly challenger suppliers but also trade bodies and a price comparison website, questioned whether the proposals were necessary to achieve the aims of better resilience. Their view was that the residual risk in the market had been materially reduced over the past year, and that further requirements would risk over-regulating the market, adding unnecessary costs for consumers. Some suppliers were of the view that if a supplier had survived winter 2021, they had demonstrated that they were sufficiently resilient and that their business model could withstand shocks, which seems to be a rather self-serving attitude.

One supplier said that the lower capital costs of legacy suppliers represented an un-earned advantage over challenger suppliers, however, it could equally well be argued that not having legacy IT systems provides challenger suppliers with an un-earned advantage. Also, small suppliers are not obliged to participate in the Energy Company Obligation or Warm Homes Discount schemes, providing them with another, arguably unearned, source of advantage.

Those supporting the ringfencing proposal noted that customers are entitled to request their money back at any time, and that ringfencing these balances would enable this.

In this new consultation, Ofgem has decided that “it is generally in consumers interests for suppliers to appropriately use some CCBs [consumer credit balances] as working capital, noting the analogies in some other industries (e.g., travel, durable consumer goods) that suggest consumers should expect credit balances to be part of an efficient business”. I assume the respondents who made these comparisons did not give permission for their responses to be published, because I could find no such references in the responses on the Ofgem website. It’s therefore difficult to comment on exactly what is meant by this, and whether the comparisons are legitimate. Elsewhere in the consultation, Ofgem specifically rejects an ATOL-style insurance scheme as used in the travel industry, so it would actually be interesting to know more about what it means when it says the use of some consumer credit balances in the travel industry might be in the interests of consumers.

Ofgem has also decided that concerns relating to over-reliance on consumer credit balances can be addressed by building on existing requirements such as the recently strengthened rules around the setting of direct debits to avoid the build-up of excessive credit balances, along with the financial resilience principles set out in this consultation. For these reasons it has dropped its plans for universal ringfencing of customer credit balances, but does plan to keep this under review.

While I have little sympathy with the position of the challenger suppliers around ringfencing of consumer credit balances, I do agree with the respondents who complained that the EBIT allowances under the price cap are too low and do not properly take account of all of the costs faced by energy suppliers. This lack of profitability deters high quality companies from adjacent sectors from entering the market, and inhibits innovation since returns are low and uncertain. As a result, Ofgem is reviewing the EBIT allowance mechanism in the price cap to ensure there is “sufficient regulatory certainty as to the returns that an efficient supplier can make”. This is positive, but we also need a change in tone from Government and a recognition that it is acceptable for energy companies to make profits, otherwise the industry is never going to realise the innovations needed to progress the energy transition effectively.

Capital adequacy regime modelled on banking

Ofgem is explicitly modelling its capital adequacy proposals on those used in the banking sectors (which again makes me question why the Financial Conduct Authority is not given responsibility for regulating the sector since it already has the operational capability for and understanding of this type of prudential regulation). It has proposed a tiering approach, with Pillar 1 Capital being the minimum regulatory buffer suppliers would be expected to maintain and Pillar 2 Capital being additional capital Ofgem may require a supplier to hold based on assessment of its risk management.

Under the proposals, suppliers will be required to provide Ofgem with an annual self-assessment demonstrating they have the financial and operational resources to meet their business requirements, risks, and regulatory obligations. This should include details of their hedging, reliance on the balancing market, presence of purchase agreements, collateral requirements, commentary on risk management based on tariffs offered, and internal stress testing methodology and processes for identifying and mitigating risks. They will also need to include a capitalisation plan that describes how they will build up to the 2025 minimum capital requirement – to credibly be on track to achieve this, suppliers should be above zero net assets within about a year.

The supplier’s Directors would be required to sign a declaration of financial and operational adequacy, approved by the Chief Financial Officer (or equivalent) to accompany the self-assessment – interestingly, there is no requirement for the supplier’s external auditors to validate the report, which seems like an oversight.

Suppliers will also be required to notify Ofgem in writing when it becomes aware of a risk it will not hold the minimum capital requirement or any of the trigger points will not be met, or of any change in circumstances that could have a material impact on their financial situation. If a supplier breaches any of the reporting triggers or the minimum capital requirements, it will have to notify Ofgem 28 days before extracting value from the business (unless for essential reasons), including, paying dividends, providing loans or transferring assets to a third party. Ofgem would have the power to restrict such value extraction if it believed the financial resilience of the supplier would be at risk.

In its previous consultation, Ofgem outlined a range of different forms that capital could take. The majority of respondents did not comment on this as they felt it was a complex area that needed further consideration. Two respondents, including Centrica, suggested that the alternative sources of funding – or contingent capital – referred to in the consultation are not loss-absorbing in a regulatory sense, saying that credit facilities and Parent Company Guarantees are at best a source of liquidity and not a source of loss-absorbing capital. They highlighted that capital and liquidity are not synonymous – a supplier can be well capitalised and but have low liquidity. These respondents suggested that regulatory capital should be defined as the financial resources a supplier has available to absorb losses, which is different from liquidity, which is resources the supplier has available to pay amounts when due.

They suggested regulatory capital can only absorb losses if it does not diminish in value or have to be repaid to a funding provider before losses are incurred – which narrows what capital should consist of share capital without mandatory dividends and distributable reserves and excludes for example senior or secured debt.

It does not surprise me that Centrica, which is regulated by the Financial Conduct Authority for its insurance business, takes this more sophisticated view of capital. Centrica as a large UK listed company also has a professional Treasury team that has a deeper understanding of financial instruments than many smaller suppliers would have. It points out in its response that a firm’s capital resources can be invested in illiquid assets, that is, assets that cannot be readily realised in cash. In this case, it may not be able to pay its debts, including customer credit balances, when required. Some of the bank failures during the financial crisis of 2007-9 were driven by insufficient liquidity rather than inadequate capital. Ofgem intends to address liquidity within the Pillar 2 capital requirement.

Ringfencing of RO receipts is retained

The BEIS Select Committee recommended that the Government legislates to increase the frequency of RO payments, something supported both by Ofgem and the market. In the absence of such legislation, Ofgem is retaining its proposal for RO receipts to be ringfenced. The new consultation contains more detail on how this can be achieved in practice, and the different protection measures that will be available to suppliers.

It is interesting that there is quite a lot of discussion about the costs of financing these measures, noting that “some suppliers are likely to face as much as 100% collateral requirements to set up a Protection Mechanism in the current climate”. I find this comment slightly bizarre: suppliers can meet their obligations by purchasing ROCs which requires the immediate deployment of capital. The alternative is to pay into the buyout fund, but if they do not set aside the money to do this broadly in line with receipts from consumers, they will have to find the necessary funding by the time of the payment deadline. It seems obvious that not ringfencing these receipts leads to a significant risk of mutualisation where poorly capitalised suppliers spend this money on normal operations and then cannot replace it.

I’m not really sure why Ofgem makes a distinction between RO receipts and customer credit balances. Allowing either to be used for working capital creates risks of cost mutualisation and both involve suppliers spending what is essentially someone else’s money to fund their operations. The complex rules for ringfencing are necessary to ensure funds are secured, but in practice a prudent supplier should already have been treating this money as segregated funds not to be used in the course of normal operations. Of course in the case of customer credit balances, it is more complex as those balances can legitimately be drawn down to fund winter gas and electricity purchases for those customers, but in the case of the RO, it is very simple…set the money aside until the payment date. Most consumers set money aside each month to pay their bills, and a lot of people will choose the payment date for mortgages and credit cards to be a few days after the receipt of wages so that important payments are taken care of first. I agree with Chris O’Shea’s comments quoted above that the public would not be very happy to hear that suppliers think different rules should apply to them.

Ensuring suppliers are run by people who are fit and proper

It seems to me that a person with integrity, meeting what a financial services professional might understand as the fit and proper persons test, upon entering the retail supply market would assess what was necessary to run the business properly and ensure they had adequate capital. This would have been more than was required by the regulator, but the laxity of the rules is not an excuse for not developing a robust business plan. If the rules subsequently become more restrictive, this would have no impact on this business model, because it had been approached from the perspective of doing things “right” and not simply the minimum required by the regulator at the time. Of course, that might make it harder to compete on price, but there is little evidence that price is the primary motivator for consumers, given low switching rates. My sympathies lie with Centrica and its peers – consumer credit balances belong to the consumers and should not be used by suppliers for working capital.

“We think Ofgem should prioritise effective protection of customer credit balances and RO in the short term to address the moral hazard currently giving rise to systemic risks. Additionally, any supplier that cannot demonstrate appropriate financial resilience without recourse to customer credit balances and RO payments should be prohibited from acquiring new customers until such time as the supplier in question has (to Ofgem’s satisfaction) hedged its commodity risk effectively or demonstrated that it has unfettered access to the requisite level of capital to mitigate the risk appropriately. To the extent that such action is not taken within a designated period, then Ofgem must assess whether that supplier’s participation in the market presents a risk to the stability of the market and energy consumers, consider enforcement against individual directors of energy suppliers and/or initiate the process for licence revocation,”
– Centrica in its response to the July consultation

It appears that Ofgem has caved in to pressure both from challenger suppliers, whose arguments hark back to the now discredited model that the success of competition is measured by switching, and from poverty campaigners such as National Energy Action which appear to be taking a short-term view that immediate additional costs to consumers should be avoided even if that means higher costs (as a result of mutualisation) later on. It is interesting that while making many comments to the press on this subject, Octopus Energy did not make its consultation response (assuming it submitted one) available for public scrutiny.

I’m not confident that the new version of its financial resilience measures go far enough, and while it can be argued that the landscape is “safer” since the riskiest suppliers have already exited, that does not mean that the remaining suppliers are all resilient. Consumers have yet to be hit with the costs of the Bulb failure and should another large supplier collapse, the costs for consumers are likely to be significant. The reality is that many suppliers who failed, and some that have not (yet), were allowed to enter the market when they lacked the resources to run an energy supply business properly – they should never have been allowed in in the first place. They cannot now be pushed out without creating further risks to consumers, but I agree with Centrica, they should be restricted from taking on new customers until they get their houses in order, and if this is impossible, their customers, and whatever credit balances are held, should be transferred to suppliers whose models are robust.

It is quite likely that there will be a further shrinking of the market – the question is whether this is done in an orderly or chaotic way. By failing to put in place robust consumer protections, Ofgem runs the risk of higher costs to consumers in the long run, while the number of suppliers falls either way.